During 2020 consciousness of SESG (Sustainability, Environment, Social and Governance) developed rapidly, and there is a broad understanding of what it is and why it matters. Providers of capital make decisions based on SESG metrics and the court of public opinion factors ESG behaviour into its judgements. Companies are therefore under pressure to improve their SESG performance. Awareness must be followed by action – prompt action. But that is not yet so much in evidence, which is surprising given the data proving the financial merits and other business benefits of engagement with the SESG debate.
Probably a major reason for this inertia is profound uncertainty about what to do and how to do it. This paper offers three core principles to help businesses understand the What? and How? of SESG, so they can deliver impactful change and enjoy the concomitant value enhancement and reputation dividend. Those principles – the Rule of Three mentioned in the title - are: Materiality, Advocacy & Authenticity.
During 2020 clients have asked: “We need to do something on ESG for our annual report/capital markets day – can you draft something?” That’s a tough one. Every business has its own SESG story and there is small benefit in boilerplate, however elegantly worded.
To reap the potential returns businesses must first integrate SESG efforts into their strategy, and then they must operationalise that strategy. Once that’s done, writing about it becomes relatively easy.
The first challenge for boards is this: identify the material SESG issues in your industry and develop initiatives for your business that set you apart from the competition. Focus on those that are hard to copy. Boards which invest indiscriminately at anything with an SESG flavour will waste cost and in all likelihood experience reduced financial outcomes. Inevitably they will have developed standardised and non-bespoke SESG behaviours. While worthy and virtuous those behaviours are unlikely to improve financial performance and generate the Alpha so coveted by CEOs.
Businesses are being judged on the connection between effective SESG behaviour and financial outcome. That connection demands an SESG strategy in which material SESG factors are prioritised and non-material SESG factors are relegated. The strategy will then be used in the business, or “operationalised”. Then it will drive results.
We now understand that there is a difference between SESG factors which, regarding financial outturn, are incrementally improving and those which have a very significant positive impact. That is a prize worth having. But it requires an approach which is ambitious rather than defensive.
Unfortunately there is evidence of a significant amount of “convergence” in the SESG universe, in which many companies copy each other’s efforts and “do similar things well”. The risk is that such behaviours become viewed as hygiene factors rather than competitive and strategic differentiators.
The hallmarks of Materiality
Not all SESG issues are created equal. Harvard Business School-led research, which looked at 2,000 US companies over two decades, found that those that invested in material ESG issues did significantly better than their competitors, while those that invested in immaterial ESG issues did worse. Evidently SESG can be a value creation opportunity, but it can equally well be an excuse for window dressing.
Of course, the G in ESG – governance of a business’s environmental and social strategy – must underpin that strategy and is critical to ensure that it is effectively implemented, maintained and improved over time. The theory and practice of good governance is well understood (albeit not always observed) and so the concepts of initiation at the highest level within an organisation (“tone from the top”); ensuring that governance is cascaded throughout the organisation (“embedding”); and using compensation structures to drive behaviours which reflect and realise that strategy, are not new to SESG. The challenge for innovation is the development of key ESG performance metrics, showing executive leadership what it is managing towards and showing the board what it must supervise and oversee.
Advocacy (The Power of Purpose)
Another feature of 2020 has been the debate around the purpose of the corporation following the 2019 signposts of the “Fink Letter” at BlackRock and the summer statement from the US Business Round Table. Much has since been written about whether the declared investor position is genuine, or whether in reality the short, medium and long term investor focus remains profit maximisation.
We know that businesses with a strong sense of culture do better than their peers. A strong culture depends on a clear articulation by leadership of their carefully developed SESG strategy, expressed so as to be readily understood and repeated by all levels within the organisation and by the outside world. This articulation and expression is what is meant here by Advocacy.
The focal audience is and remains investors, bearing in mind that enduring access to capital is the oxygen without which no business can survive and prosper. Again this is not limited to the field of SESG, but it is important that due weight is given by boards to ensure that their communications with investors embrace SESG too. So far it isn’t clear that this is happening. There are various reasons for that, some well-founded and others less so.
Misconceptions include that investors place little value on corporate communications. We know that the opposite is true, but only for communications that are honest, transparent, relevant and specific. Boards that invest solely in securing SESG ratings are unlikely to hit the spot as far as investors are concerned.
Authenticity: aligning words and actions
If there is not a close and continual association between (i) the declaration by any businesses of its purpose and SESG strategy; and (ii) its behaviour in manifesting those things, then the value of its efforts in relation to SESG will be severely and rapidly undermined; its resilience in the face of business risks eroded and its reputation diminished. There will be practical consequences of these things in reducing its access to financial and human capital and ultimately in its market access and license to operate.
The lack of a consistent standard for SESG disclosures is a current reality despite a number of high quality initiatives, some with a global reach, to correct that situation. Why does that matter? Because the fact/description disparity of which greenwashing is one instance is a litigator’s charter. Together with a piecemeal SESG regulatory landscape, that creates an environment in which the disciplined application of the principles of Materiality, Advocacy and Authenticity become non-negotiable risk mitigation tools for any business leadership team.
It is no longer attractive or interesting for a business to show SESG awareness and intention. Such a business must have an SESG strategy which: is consistent with its corporate purposes; focuses on issues material to the business; is underpinned by its culture and values; and is resilient to competition and replication. Its leadership must show that it can deliver, against specific, time-linked and measurable objectives and with regular communication of progress towards the achievement of those objectives. Boards must be brave enough to extend that advocacy externally, and it must be protected by the authenticity that makes it truly useful to investors.
Alex Tamlyn is a Partner at DLA Piper UK LLP and Chair of the London Stock Exchange Primary Markets Advisory Group.